Not since the Tax Reform Act of 1986 more than 30 years ago have we seen such change impacting our market, affecting both the structure of issues being offered as well as the composition of investors who are purchasing these issues.
Here, we address some of the significant changes currently driving municipal bond issuance volume and structure in this market and provide insight into how these changes may affect the way your organization finances its capital projects.
This article is the third in a four-part series of articles:
- Alternatives to advance refundings post tax cuts and jobs act of 2017
- Changing investor preferences for municipal bonds
Private placements in the issuance of bonds are increasing
Since 2010, we have seen a marked increase in the use of private placements to finance capital projects. As the chart below shows, private placements increased more than 385% between 2010 and 2017. Although the last two years have shown a decline in private placement activity, likely due to a decrease in corporate tax rates for most banks beginning in 2017, the year-to-date 2020 activity is showing signs of increasing once again as municipal yields have become more attractive on a relative basis.
In this article we will discuss how a private placement differs from a traditional public sale, and some of the reasons we have seen such a significant rise in this method of financing in recent years.
Private placement v. public sale
A public sale of bonds occurs through:
- A negotiated sale in which an underwriter (broker/dealer) is engaged to assist in structuring the bond issue, and to market the bonds to potential investors in the days and weeks leading up to the sale
- A competitive sale in which the issuer solicits bids from underwriters on a specific date based upon information provided in a notice of sale.
On the day of sale, the underwriter will establish the interest rates for the bond issue based upon prevailing market rates, and offer the bonds through a public offering to investors.
An offering document (also known as an official statement) is used during the marketing and sale process to provide investors with all the information a reasonable investor would deem material in the purchase of the bonds. This includes information about the structure and security of the bond issue, as well as a detailed description of the covenants, call provisions and source of payment for the bonds. It also includes detailed information about the issuer or obligor, including financial information and statistical information concerning its operations and competitive environment.
For publicly sold bonds, issuers are normally required to enter into a continuing disclosure agreement in which they agree to provide certain information to the market on an annual (and sometimes quarterly) basis to keep bondholders informed about material information and changes occurring with the issuer. This continuing disclosure agreement also helps facilitate secondary trading of the bonds in the market.
This underwriting process is the traditional method of sale for most bond issues, and leverages the marketing and distribution capabilities of the underwriter to generate investor interest in the bond issue. It also leverages the market knowledge of the underwriter in setting the interest rates for the bond issue based upon the prevailing interest rate environment.
In a private placement of bonds, a placement agent will be engaged to assist the borrower in placing the bonds with one or a few institutional investors without going through the underwriting process used in a public sale.
The placement agent will typically assist the borrower in identifying potential institutional investors, and negotiating the placement of the bonds through the use of a term sheet or placement memorandum. The term sheet sets forth key information regarding the proposed financing structure, but is not intended to provide all material information that a reasonable investor would want or need to know. Rather, each potential investor is required to perform its own due diligence on the issuer/obligor and the proposed financing.
As a result, a sale of bonds through a private placement is limited to sophisticated investors, which are typically financial institutions (banks, mutual funds, insurance companies, etc.). Bonds are offered in minimum denominations of at least $100,000, and each investor is required to sign an investor letter in which they affirm they are a sophisticated investor purchasing for their own account and not with the present intent to re-sell the bonds. They also acknowledge that any future resale of the bonds will be restricted to sales to other sophisticated investors.
Since the bonds are not sold publicly, a continuing disclosure agreement is not required in the sale of the bonds. However, the obligation to provide ongoing financial and material information to the investors in a private placement should be expected, even if not required to be filed publicly.
Because the re-sale of privately placed bonds is restricted to other sophisticated investors, they are less liquid than bonds that are publicly offered. As a result, investors will typically require an interest rate premium to compensate for this illiquidity, which increases the borrowing cost to the issuer.
One way to help increase the liquidity of privately placed bonds in the secondary market, and potentially reduce the interest rate required by investors, is to obtain CUSIPs‡ for each maturity and register the bonds through the Depository Trust Company (DTC). The bonds must still have minimum denominations of $100,000 but registering through DTC may help facilitate the future transfer of the bonds to other sophisticated investors. Certain investors, however, may prefer that the bonds not be eligible for registration through DTC.
Why have private placements become more common?
There are several reasons why private placements have become more common in the last several years:
- The cost of funds for most banks has been very low over the past 10 years, which has enabled them to be more competitive relative to the traditional bond market.
- Banks have the option of holding privately placed issues as either a loan or a security.
- Institutional investors have become more familiar with the process of directly purchasing bonds from municipal issuers.
- Perceived lower cost of issuance – since an official statement is not used in the marketing and sale of the bonds, the time and expense associated with drafting this disclosure document is not required.
- Less time and resources required of the issuer – the information typically included in the official statement regarding the finances and operations of the obligor, along with its competitive environment, is not required (although due diligence requests from potential investors must still be satisfied).
- Ability to customize financing structures – since privately placed bonds are typically placed with one or a few investors, they can allow for customized structures not typically available in the public sale market, such as draw note structures, “cinderella” bond structures, or more flexible call provisions.
- Avoid market volatility and pricing uncertainty – recently the municipal bond market has experienced extreme volatility with interest rates fluctuating significantly day to day, which may be a deciding factor for issuers considering private placement instead of selling their bonds publicly.
- Limited continuing disclosure obligation – although some continuing disclosure will likely be required for a private placement, public dissemination of that information may not be required.
Is a private placement the right approach for your project?
Deciding whether a public sale or private placement is the best approach for your project requires a careful analysis of the costs and benefits of each option. This analysis should consider the anticipated interest rates for each option, along with the anticipated costs of issuance and any customization required in the financing structure to meet your specific project needs.
The public finance group within UMB Bank n.a.’s Investment Banking Division are committed to helping communities and organizations fulfill their quality-of-life and growth aspirations. Visit umb.com to learn more about how we can support your organization, or contact us to be connected with an investment banking team member.
This communication is provided for informational purposes only. Municipal private placement services are offered through the public finance group within UMB Bank n.a.’s Investment Banking Division. Corporate private placement services are offered through UMB Financial Services, Inc., by dual employees of the public finance group and UMB Financial Services, Inc. UMB Bank, n.a., UMB Financial Services, Inc. and UMB Financial Corporation are not liable for any errors, omissions or misstatements. This is not an offer or solicitation for the purchase or sale of any financial instrument, nor advice with respect to municipal financial products or the issuance of municipal securities, nor a solicitation to participate in any trading strategy, nor an official confirmation of any transaction. The information and opinions expressed in this message are solely those of the author and do not necessarily state or reflect the opinion of UMB Bank n.a. or UMB Financial Corporation. UMB Bank n.a., 928 Grand Boulevard, Kansas City, MO 64106
UMB Bank, n.a. Investment Banking Division is a division of UMB Bank, n.a. UMB Bank, n.a., is an affiliate within UMB Financial Corporation. UMB Financial Services, Inc., Member FINRA, SIPC, is a wholly owned subsidiary of UMB Financial Corporation, and an affiliate of UMB Bank, n.a.
Securities offered through UMB Bank, n.a. Investment Banking Division and UMB Financial Services, Inc. are:
NOT FDIC INSURED | MAY LOSE VALUE | NOT BANK GUARANTEED